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Yuan Weakness Reflects Economic Reality in China

Official data from China this week may reinforce the view that the economy is close to, if not at, a bottom, but the country's currency seems to be telling a different story.

The Chinese renminbi posted its first annual decline this year since 2005, dipping 1 percent to 6.3676 versus the U.S. dollar. The currency had gained nearly 22.3 percent from July 21, 2005 -- when the Chinese government abandoned the currency's 8.11 peg to the greenback and allowed it to trade within a designated band -- to the end of 2011.

Analysts say the falling yuan reflects a slowing economy, and further loosening of the exchange rate system will likely trigger further weakness, rather than strength, in the currency.

Boris Schlossberg, Managing Director of BK Asset Management in New York, says a "massive source of appreciation" for the currency in the near term is unlikely, as the Chinese economy is actually slowing "markedly."

"I think one of the greatest ironies in the world is that if they allowed the renminbi to float at this point, it may actually weaken because if you look at the dynamics of the Chinese economy, there's a tremendous amount of over-leverage and lots of mal-investment," Schlossberg told CNBC Asia's "Squawk Box" on Wednesday. "And it's not necessarily clear that investors are going to rush in and buy the renminbi if they allowed it to float. So I think it's reflecting the economic reality on the ground."

His views are in contrast to that of Washington's, which has repeatedly pressured Beijing to initiate further reforms on the yuan, believing that the currency is artificially low and gives the China an unfair trading edge.

Lim Say Boon of DBS agrees that the yuan "is not a one-way bet."

"For the longest time, what we have been seeing, what we have been hearing from the market is, look, this is a sure thing. It's either we get moderate appreciation or we get strong appreciation. That's certainly not true," said the Chief Investment Officer of DBS Private Bank.

Over the longer term, the yuan could see "moderate" appreciation but that doesn't mean that investors won't get negative returns on the renminbi from time to time, Lim said.

Softness Prompts Capital Outflows

Markets will be combing through a slew of data that China is releasing on Thursday, including consumer price index , fixed asset investment, retail and industrial production.

Investors hoping for signs of an economic pickup may be disappointed, analysts say, and the picture could be worse than what the data reflect.

"The official data tell us one story, but the unofficial data tell us another," Sodhi told CNBC. "If we look at what's happening with electricity production across the country, cement production, car sales, there's a whole host of associated data that suggest that China is definitely slowing probably more than we would have expected."

This weakness prompted domestic firms and individuals in China to pull money out of the country in the second quarter of the year to the sum of $71.4 billion, the fastest pace in the last decade, and increased their holdings of foreign currency, according to data from the nation's foreign exchange regulator last week. The capital and financial account had a surplus of $56.1 billion in foreign reserves in the first quarter, the State Administration of Foreign Exchange said.

This is another reason the renminbi has softened in recent months, Schlossberg added.

"I think there's a lot of what you may want to call smart money, or scared money, but there's clearly cautious money starting to pull itself out of China as investors are beginning to feel that the investment boom may be starting to peak," he said. "There's clearly a tremendous amount of non-performing loans on the books (of banks) that have to be taken care of. So China remains a big open question."

- By CNBC's Jean Chua.

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